The fraud allegations against Valeant exposed an industry secret that's going to infuriate Washington

Whether you believe accounting fraud allegations levied against pharmaceutical firm Valeant or not, one thing is certain.

The pain isn't over -not for Valeant, not for any company in the pharmaceutical industry.

That is because what is really at the heart of the accusations against Valeant is the use of a new, shadowy segment within the pharmaceutical industry that will only add to the government's intense scrutiny of its drug pricing practices.

This new segment is known as "specialty pharmacy."

Specialty pharmacies are used by some big drug companies to administer and distribute their product.

What's more, using a specialty pharmacy is considered an advantage for a big drug company because they can be used to bypass insurance companies that may want patients to use a lower cost drug than the one a doctor prescribes (i.e. a drug a drug company wants to sell).

Matter of perspective

So if you (a drug company) have a specialty pharmacy at your disposal, you get more of your product sold. Once the product is sold, you then try to get whatever you can from the insurance company. Whatever you can't collect, you take as a hit. The volume of product sold offsets the loss.

Here's how Bernstein Research explained it in a recent note [emphasis theirs]:

"Is this not illegal or at least immoral? The core services provided by specialty pharmacies are not illegal. As for immoral - it's a matter of perspective."

"The payer (and employer) intentions are being undone which can be viewed as wasting precious resources by taking advantage of an inefficiency in the system. The counter view is that patients get to use the drug the physician prescribed and avoid unnecessary hassle. One investor called us a 'socialist' for suggesting system benefit should sometimes come first."

The advantage for the drug company here is clear, and that's why big drug companies don't really talk about their relationships with specialty pharmacies.

Unless, of course, those relationships are under fire. And that's what we have here, an industry secret under fire.

Secret's out

On Monday Valeant held its third quarter earnings call and disclosed that it has a contractual relationship with a special pharmacy called Philidor. CEO Michael Pearson said that it never disclosed the relationship before because the relationship is considered a competitive advantage within the industry.

However, ever since the government started scrutinizing Valeant for its pricing practices last month, both the press and the Feds started asking questions. That's why Pearson started talking about Philidor.

"We have a contractual relationship with Philidor, and late last year we purchased an option to acquire Philidor if we so choose," said Pearson.

"Given accounting rules, we consolidate Philidor's financials. Inventory held at Philidor remains on Valeant's books, and is not included in the specialty pharmacy channel inventory."

Remember those accounting rules, because that's where short selling firm Citron Research comes in. On Thursday Citron published a report accusing Valeant of invoicing a specialty pharmacy within Philidor's network, R&O, for selling $69 million worth of product R&O claims it never received or sold.

They don't know, we don't know

In levying this accusation, Citron cites a filing in California Court in which R&O says it has no idea what Valeant is billing it for.

Here's an excerpt from the filing:

On September 4, 2015, R&O received a letter from Robert Chai-Onn, Valeant's Executive Vice President, Chief Legal Officer and General Counsel. In the letter, which was the first correspondence that R&O had ever received directly from Valeant, Mr. Chai-Onn claimed that R&O, a small licensed California pharmacy, owed Valeant over $69,000,000.

However, R&O has never received a single invoice from Valeant in any amount and until September 4 had never received a single demand for payment from Valeant. R&O has requested copies of the invoices, but to no avail. Indeed, it seems that Valeant has no evidence whatsoever to back up its claims.

Therefore, R&O believes that one of two things must be true:

1. Valeant and R&O are victims of a massive fraud perpetuated by third parties; or

2. Valeant is conspiring with other persons or entities to perpetuate a massive fraud against R&O and others. The purpose of this action is for R&O to get to the bottom of this, avoid accrual of avoidable damages, if any, and secure an early adjudication without waiting until Valeant sees fit to file suit.

In a statement, a Valeant spokesperson "categorically denied" Citron's report. However, it did not directly address R&O's court filing, which also alleged fraud.

It said only the following on R&O:

The $69 million at wholesaler acquisition cost of products shipped by Valeant to R&O were not recorded as revenue to Valeant when shipped to R&O. When R&O dispensed those products Valeant recognized the net realized amount due from patients and payors (approximately $25 million) and reduced the associated inventory from Valeant's balance sheet. In this case, we estimate the net amount of revenue for the $69 million at WAC would be approximately $25 million.

At best, this mess is just a misunderstanding between companies with tons to keep track of - it's some some lost paperwork, some forgotten product.

Either way, what all of this does is highlight how little we know about how these companies work together within an industry that means the difference between life and death for millions of people.

Mark Wilson/Getty Images

Senator Claire McCaskill (D-MO) sent a letter asking Valeant questions about its pricing practices earlier this month.

And then a bomb went off

Valeant's accounting practices have been a target for short sellers for years now, ever since Kynikos Associates founder Jim Chanos accused the company of using aggressive, acquisition driven accounting to hide its lack of organic growth.

Citron's fraud accusation, though, is about more than accounting. It's about pricing, and that's what everyone from Hillary Clinton to Senator Claire McCaskill (D-MO) have been coming down on big drug companies for.

Since specialty pharmacies give big drug companies the ability to bypass insurance companies looking to cut costs, analysts see them as a potential way costs are driven up.

Pricing is power

In other words, Citron's report got Wall Street scared that the government - already angry and asking a load of questions about pharmaceutical pricing - would start looking into these special pharmacies.

Traders sold Valeant until it was down almost 19% for the day even with a boost from billionaire investor, Bill Ackman, the company's third largest shareholder.

In fact, when Citron's accusations came out big drug companies got hurt across the board as the market tried to figure out which companies were vulnerable.

Allergan, a $101 billion firm Valeant once targeted for takeover, had to release a statement saying that it doesn't use specialty pharmacies at all when its stock dipped around 7% during the trading session. It later recovered to close the day down about 1.7%.

So the specialty pharmacies are an issue that will keep Valeant, and the entire industry, in the government's crosshairs until it figures out how they work.

"Our view is that like any other commercial practice, pharmacy practices can also cross the line, but presumably this risk is on a company-by-company basis," Bernstein wrote in its note.

"That said, two enhanced concerns were flagged that we can't argue against - (i) specialty pharmacy is a 'young' industry segment and thus may be under regulated (this is still a pharmacy, though, and those are regulated) and (ii) in-house pharmacies are riskier for the owner than arms-length relationship with a separate party. Fair."